I've seen this a couple times where the onus is mostly on the later-stage investors. They know the terms, and they know exactly what they need to say to lock out the earlier stage investors and take over a bigger portion of the round, so they start pushing levers to see what they can get to move, playing on the FUD of the founders that they might not be able to raise from somewhere else.
What a terrible place to be put in as a company: A big opportunity you're incredibly excited about, but contingent on you screwing over the people who have helped get you to where you are in a small way.
I would encourage any founders who are put in this type of scenario to fight back hard. Investors that are worth their while will respect your loyalty and your refusal to go back on your word. If I were a later-stage investor who proposed something like that and the company came back strong saying, "That's not even on the table, because we're not going to do something below the belt" I would gain additional respect for that company.
Keep in mind that unless the existing investors actually sign something agreeing to this, it cant happen. Many likely do sign, because they think that getting big-namebrand-investor onboard is worth the haircut. If they don't want to do it, they don't have to. If the company does it anyways, they would have a slam dunk legal case to reclaim their ownership. Majority shareholders diluting minority shareholders for their own benefit is probably the most common business dispute there is.
This has traditionally been the role of unions and why YC has morphed itself into a de-facto founders union to better negotiate terms like this across a collective of founders.
I wouldn't be surprised if this sort of thing were a test. If you're not willing to screw over the earlier investors, you are clearly not ready to manage a large company. Large companies run on 'if I don't do it a competitor will and then we'll lose', not on being good people. Especially considering that white collar crime is very rarely punished, and then only with a slap on the wrist, such crime is expected in such circles.
I'm not sure this is such a terrible place for founders to be put in. It's pretty straightforward, as ethical dilemmas go. "Excitement" comes nowhere close to justifying breaking your word.
> It's pretty straightforward, as ethical dilemmas go. "Excitement" comes nowhere close to justifying breaking your word.
Agreed - this is inexcusable.
If you lose an investment because a later-stage investor is keen on you cheating existing investors out of what you already promised them, I'd say you dodged a bullet - you don't want them owning any piece of your company.
If your later-stage investors are so keen on working with investors who are willing to renege on their promises and legal obligations to earlier investors, that says something about:
(A) The types of entrepreneurs they want to work with
(B) How they themselves can expect to be treated in later rounds, when they are now the "earlier investors".
And if your Series A investor denies pro-rata rights to your seed round investors, then it should expect to have its pro-rata rights denied in Series B. Which gives this Series A investor a perverse incentive to set up the company to look better in the short term to get it to Series B, rather than it acting in the IPO-timescale long-term interest of your company!
I wonder how straightforward an ethical dilema it is. When signing a contract, are you ethically obligated to follow the terms of the contract, or are you merely agreeing to something which can be enforced by the terms of the contract, including penalties and lawsuits. Most people do business in the latter way: a contract is only as good as the "teeth" that make it unprofitable to violate it.
> When signing a contract, are you ethically obligated to follow the terms of the contract, or are you merely agreeing to something which can be enforced by the terms of the contract, including penalties and lawsuits.
Ethics have nothing to do with the likelihood of getting caught or any potential penalties after being caught.
Some people do do business in that way, sure, but that doesn't change the ethics of those actions.
It's straightforward as an ethical dilemma, but maybe not as a practical/CEO dilemma. Are you willing to risk the future of your company, your employees and finally, your own future (by failing to raise another round) on keeping your word?
Now, of course, if it's such a hot startup that investors are cramming to get into a round, it probably less of a dilemma. But that might not always be the case.
Yes? I'm still not clear on why this is difficult.
The reality is that the decision is probably never between the future of the company and honoring your promises. It would be irrational for an early investor to allow the company to die in order to preserve their percentage stake in a zeroed-out investment.
The behavior contemplated in this blog post isn't that dilemma. It's "this conversation with early investors is going to be sticky, and will involve some form of concession to them --- therefore, we're going to exploit their lack of leverage and bulldoze through them." That's unethical. It's not a tragic dilemma. It's being presented with an opportunity to harm someone for your own convenience, and all that's asked of you as a human is to simply not do that.
What I have in mind as the dilemma is exactly the fact that is is rational for the early investor to accept the terms of the latter round, which is why they are likely to get screwed. The dilemma of the founder, to me, seems to be whether (1) to go along with whatever terms the latter investors propose, even though you know it's not fair to the early investors, because you know that it's rational for the early investor to accept them, or (2) to stick out with the early investors and only accept further investment provided they honour your agreement (and not try to strong-arm the early investor in giving up their rights), even though it's not rational for you (the founder) or your company to do so (however, it's rational for you+early investor).
It's similar to the story that was on HN earlier - founders that had great exists had rewarded their employees with additional equity/cash, even though they were neither rationally nor legally bound to do it - but they did it anyways, because it was fair / the right thing to do.
That's the sort of dilemmas I'm talking about, and I believe the original article is talking about.
"(2) to stick out with the early investors and only accept further investment provided they honour your agreement (and not try to strong-arm the early investor in giving up their rights), even though it's not rational for you (the founder) or your company to do so (however, it's rational for you+early investor)."
The rationality of ethics depends on everyone believing they are part of a multi-round game.
Hint: even if you think you are playing a single round game, you probably aren't.
Founders realistically have to pick and choose their battles. If a founder raises a seed round from 10 investors who each invest a five figure amount, and eight of those 10 investors do little to nothing after writing a check, it's difficult to expect the founder to go to bat for them if push comes to shove.
In an ideal world, everyone would honor their agreements. In the real world, the behavior Aaron is describing is happening whether we like it or not.
Angel investors who are concerned about their pro rata rights can't pretend that they exist in an ideal world. They can do one of two things: passively accept whatever they get, or take action in an effort to get what they want.
If you recognize the motivations of founders (and the pressures they may be put under), it is clear that the behavior of the angels themselves can either incentivize or disincentivize founders when it comes to honoring the obligations they made under different circumstances.
It's possible to behave ethically in a fallen world. It's not even that hard. Your pose of hard-nosed realism is actually more repugnant than just straight up saying "I'm breaking my agreements because I want to".
> It's possible to behave ethically in a fallen world.
You're absolutely right. It is. But as an investor, you are bound to get hurt if you assume that everybody you're conducting business with will do so. Again, you can either deal with the world as it exists, or lament the fact that it isn't perfect.
In boxing, fighters are instructed to protect themselves at all times. That approach is a decent one outside of the boxing ring too.
What parts of your life are subject to ethics, then? Is it just investment, or are there are other circumstances where you feel like you have to choose between ethics and the law of the jungle?
> ...are there are other circumstances where you feel like you have to choose between ethics and the law of the jungle?
I can choose to conduct myself in an ethical manner. I can't assume you will do the same. Get it?
If you go through life under the mistaken assumption that nobody is willing to hit below the belt, and you never take action to prevent and defend against such blows, you will eventually be hurt. There's nothing wrong with accepting the fact that some folks will play dirty, and please don't fall into the trap of believing that taking action to protect your interests requires you to play dirty too. It doesn't.
Once again, if you acknowledge the motivations of other individuals and the pressures they might come under, you are less likely to be caught off guard by actions they might take in response to them. If you adjust your behavior accordingly, you can often incentivize them to do the right thing when they otherwise wouldn't had you acted passively and/or obliviously.
Am I misreading you? It sounded like earlier you were saying that it's justifiable to ruthlessly renege on agreements because if you don't, you're sure to take losses. If that wasn't what you were saying, I made a mistake, and apologize.
To be fair, I can see how my original comment could be misread. I wasn't endorsing the behavior being discussed, I was simply trying to convey the idea that investors should accept reality: most founders are going to pick and choose their battles. Realistic investors shouldn't expect founders to go to bat for them unless they have an incentive to.
Example: if you invested $25K in a $250,000 seed round and haven't talked to the founder in six months, don't be surprised if he doesn't fight tooth and nail for your pro rata rights.
If you want to write a contract to the effect that the investor retains pro rata rights provided he/she does X, Y, and Z, you can certainly do that. If the contract doesn't say that, then that wasn't your agreement.
-- Ah, I understand. Your comment is addressed to the seed investors, not to the founders. As such, it's a fair point. The question of how the investors should behave is not what we're discussing, though.
I am currently on the other side of the table. I have a startup that is doing well in traffic, but running out of money quickly. I want to sell the company, and I have several buyers, but my investors who have common stock are threatening to kill any deal I bring unless they get above and beyond their pro-rata shares.
At least the investors in this article have the option of not signing whatever paperwork the new investors push on them. Much harder situation for me as I risk walking away with nothing unless I give more than our investors are entitled to.
Hey, I think you might be slightly confused on some terminology.
Pro-rata is about investing MORE money into the company when you raise a round, to avoid being diluted. It's not something you can get "above".
I think you're talking about liquidity preferences here, which are a separate issue. You could get returns "above and beyond" liquidity preferences, so I'm guessing that's what your investors are actually talking about.
Can you share the rough deal size and investor payback? Most investors have 1x liquidation preference, and I can totally see them getting at least that, even if they didn't write it into the contract; but if they are asking for more than 3 or 4x on a short term deal, then they're just being greedy.
I would like to keep it confidential, since my investors likely read HN. Deal size was above 5 million but less than 10 million. They are pure common, no liquidation preference or anything like that. For all intents and purposes they hold the same shares and rights as myself.
They invested more than they would receive in a sale under pro-rata terms, so they would have a loss, but still a partial return on investment. You say I should honor terms not written into a contract and give them a 1x preference? Seems silly to me. If they wanted those terms, they should have negotiated it. I do not feel entitled to give them more than what they negotiated for. These guys are a professional fund and this is the name of the game.
Unfortunately, it looks like unless I cave they will just let the company die. They ultimately know that the sale means much more to me than it does to them. All the pressure is on me, to end up with 'fuck you' money. They likely do not care about the money as much as not having to write down a loss or something. If I was to give them what they want, I would walk away with close to nothing after having spent significant time working for almost no salary.
Well here is the truth of the matter: If your investors get their money back you'll probably get investors again. If your investors do not get their money back, it will be much harder to raise next time.
Pro rata is most important in the case of a down round. Your ownership really dilutes in that situation.
For what it's worth, I've definitely been asked nicely if I would consider not taking my prorata because space is needed. When things are THAT tight I am often asked to sell shares to the new investor as well.
In some cases this could be angel investors simply not doing what's in their best financial interest, either short-term or not at all.
If one gets the reputation of always giving up one's pro-rata rights, then you might as well not have them, right?
It's interesting to consider in what circumstances consenting to surrendering their pro-rata might be rational behavior.
The surrender is financially equivalent to doing the round at a lower valuation -- as angel investors have effectively sold their pro-rata rights back to the founders, who give them to the new investors. However, compared to simply doing the lower-valuation round, this approach saves more face for the angel investors.
This behavior of the VCs towards angels is as old as the hills. They want control and will screw with anyone who stands in their way. In fact, I have long speculated that a requirement to make partner at some firms is how smooth you are when screwing over a founder or angel.
The truth is that the smaller investors don't have leverage. And so they swallow hard and sign the paperwork. I applaud YC trying to stand up for the little guy, but I fear they will be unable to fight the seduction of founders of hotshot companies by big-name big-money VCs whispering sweet nothings into their ear.
Forgive me if this is a naive question, but why are pro-rata rights considered standard? It seems like it's essentially the right to dilute founders in the future to maintain your ownership. Yes you're investing early, but that's priced into the valuation. I suppose the right has value, so perhaps a lower valuation would be justified. But why do pro-rata rights always elicit this moral outrage when called into question?
You're conflating two very different sources of moral outrage. One is that, prior to investors and founders memorializing their agreement on pro-rata rights in a contract, some investors feel like they're entitled to them because they're a standard term. One reason why they're standard is detailed below.
The present controversy is that after investors/founders committed to pro-rata rights, later investors convinced founders to not honor those pre-existing commitments.
Yes you're investing early, but that's priced into the valuation.
Many investors would say "If you're investing and not getting pro-rata rights, the valuation you've negotiated is not a meaningful number, because it can be retroactively renegotiated by parties who do not necessarily have to include you in that conversation. It is thus not conveniently possible to award investors with, nor desirable for investors to seek, an attractive valuation for taking on extra risk by investing early unless that attractive valuation comes with pro-rata rights."
Agree, you're right on honoring the term once it's been agreed to. Lazy conflation on my part.
I'm not sure I follow how the valuation is retroactively renegotiated. Later investors can't dilute an angel unfairly without diluting the founders unfairly too. In cases where the investor dilutes the angel but issues new shares to founders, the angel can simply veto the financing, right? Or are you saying a 5MM premoney valuation with pro-rata rights would be worth vastly less without pro-rata, so much so, that it's a nonstarter?
If the pro-rata rights exist, it's seems obvious that trying to void them is at least unethical.
But pro-rata rights make perfect sense to me. I don't see it as "the right to dilute founders" but more "thanks for taking a risk on us when it was far from clear that things might work out...I know your economics necessitate a follow on like this".
Agreed on the first point, I didn't mean to say honoring the contract is up for debate.
On the second, yeah I'd want my helpful early investors to continue to be meaningfully invested. But what about unhelpful ones? I guess I'm asking why is it standard to promise this right before you've worked with an angel. The angel took a risk, but that risk was priced into the valuation in theory.
I'm in India. A ROFR was also once considered standard here. "We took the early risk, so we should get first dibs on the whole round." That went south because it was jeopardizing fundraising and angels didn't have deep enough pockets to do whole Series As anyway. I guess I'm applying the same logic there. If a pro-rata jeopardizes fundraising and causes all these headaches, why not just take it out and adjust the angel round valuation accordingly.
The angel has little power against later VC rounds besides the protections he negotiated for upfront. Since it's purely in the VC's interest to screw the angel, the angels make it a standard to negotiate this protection. And of course people get upset when a negotiated protection is tossed aside.
Would it be worthwhile to name-and-shame VCs that are pushing for this? Knowledge that some VC demands the startups they fund be willing to break their word should mean startups they fund aren't worth our trust, which should destroy a lot of their value.
Why would a fund want to participate in a series A with an entrepreneur who screws their investors? Wouldn't the logical conclusion be to screw the series A investors when they go to raise a series B?
Let us give the super angels the benefit of the doubt. They probably know that their pro-rata rights are not always enforceable and price this into the valuation. Good for them if they can keep them but they are probably at all surprised if they don't. It is a numbers game for investors.
laughing at the default variables in the spreadsheet. ludicrous the idea that you can get a 50x return by owning a 1% of a company that was seeded at a $10m valuation.
....and lets just assume a $1B exit for arguments sake! haha, this guy must be raising money for a seed fund or something.
--
oh yeah, and the fact that prorata shares actually cost you something, you don't get them for free as Aaron seems to think.
Why is that ludicrous? I've gotten > 50x return multiple times. If you invest in winners, it's not unreasonable -- that's where most of the money is made in this business, and why it matters to not get squeezed out of the big hits.
I often pass on my prorata simply because it would be too expensive to keep up with, and it would mean not investing in new companies. Since that's the fun part, I am happy to do that instead.
Theoretically, you could form special purpose vehicles with the intention to exercise your rights without putting a lot of your own money in. But yeah, I am with you, on the most successful companies, valuation ends up being too high for a seed investor anyway
Maybe pro-rata would be more palatable if it was not assignable? It makes sense to me that early investors get a shot in later rounds. Whether they should be able to maintain percentages is a different topic. Without ability to assign, I suspect many might not maintain percentage anyway.
Yes, the numbers are absurd. I feel sorry for LPs in any seed fund run by somebody who is handing out $10 million valuations.
As for the $1 billion exit, according to CB Insights, in 2013, 19 tech companies went public or were acquired at a billion-plus valuation. That represents slightly more than 1% of all exits. Over 70% of the exits were under $200 million. So any angel banking on billion dollar exits would probably be better off going to Vegas.
The rule of thumb is that 20% of a venture fund's investments produce 80% of the returns. Outside of the top performing funds, those returns are generally not eye-popping.
The economics of a seed stage fund differ from a traditional venture fund. Stakes are a lot smaller and the number of portfolio companies is a lot larger. Maintaining a stake can be difficult, even with pro rata rights, because the cost of participating in future financings can be too high.
Valuation is absolutely crucial to successful startup investing at the seed stage. A seed stage fund that hands out $10 million valuations like candy is not likely to be very successful. Based on the percentages, a seed stage fund that has several hundred companies in its portfolio is still unlikely to see a billion dollar exit. According to CB Insights, 45% of exits in 2013 were at valuations under $50 million. Do the math. If you invest at bloated valuations at the seed stage, you're not statistically likely to produce great returns when all is said and done, even if you are better than most at selecting companies that have liquidation events (most don't obviously).
What a terrible place to be put in as a company: A big opportunity you're incredibly excited about, but contingent on you screwing over the people who have helped get you to where you are in a small way.
I would encourage any founders who are put in this type of scenario to fight back hard. Investors that are worth their while will respect your loyalty and your refusal to go back on your word. If I were a later-stage investor who proposed something like that and the company came back strong saying, "That's not even on the table, because we're not going to do something below the belt" I would gain additional respect for that company.